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    Understand the Fundamentals of Bonds: Definition, Pricing and Real World Examples

    Bonds are financial securities that mimic loans that investors make to borrowers like businesses and governments. The final date for principal and interest payments is one of the loan’s terms. Borrowers utilize these fixed income instruments to fund operations and projects.

    Interest payments, which are often called “coupons,” are given back to the bondholder who lends the borrower money. A bond’s market price can change depending on elements like the issuer’s creditworthiness, the length of time before maturity, and the coupon rate.

    The face value of the majority of them is paid back to the lender when they mature, whether they are exchanged publicly or privately. These can be put into one of four main groups, and some markets also sell foreign bonds from governments and multinational companies.

    In a Nutshell

    • The meaning of ties is bonds are fixed income securities that represent loans made by investors to borrowers, who are typically businesses or governments.
    • Governments and corporations issue a bond, which are debt instruments, to borrow money for a variety of uses, such as financing infrastructure improvements or company growth.
    • Bonds function by enabling numerous individual investors to lend a portion of the necessary funds. The loan conditions and interest payment are stated in a bond that the borrower issues. The interest payment received by bondholders is based on the coupon rate.
    • Bond characteristics: The majority of bonds have a $1,000 face value, and their market price is influenced by the issuer’s creditworthiness, the length of time before maturity, and the coupon rate in relation to the overall interest rate environment.
    • Bond types: There are four primary types of bonds available on the market: corporate, agency, municipal, and Treasury. While some bonds are traded openly, others can only be done so privately or over the counter.

    Who Issues a Bond?

    These are debt instruments and represent loans made to the issuer. Governments (at all levels) and corporations often use bonds to borrow money. Governments need to finance roads, schools, dams or other infrastructure. The sudden expense of a war may also necessitate the need to raise funds. Similarly, companies often borrow money to grow their business, to buy property and equipment, to undertake profitable projects, for research and development or to hire employees.

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    The problem for big businesses is that they often need a lot more money than a typical bank can give them. These offer a solution by allowing many individual investors to take on the role of lenders. In fact, government bond markets allow thousands of investors to each lend a portion of the needed capital. In addition, the markets allow lenders to sell their bonds to other investors or to buy bonds from other individuals, long after the original issuing organization has raised the capital.

    No man is an island, entire of itself; every man is a piece of the continent.

    John Donne

    How a Bond Works

    These are commonly referred to as “fixed income securities” and are one of the main asset classes with which retail investors are often familiar, along with equities (stocks) and cash equivalents. When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance existing debt, they may issue these directly to investors.

    The borrower (issuer) issues a bond that includes the terms of the loan, the interest payments to be made, and when the borrowed funds (bond principal) must be repaid (maturity date). The interest payment (the coupon) is part of the return that bondholders earn for lending their funds to the issuer. The interest rate that determines the payment is called the coupon rate.

    The initial price of most bonds is usually set at par, i.e., $1,000 par value per individual bond. The actual market price of a bond depends on a number of factors: the credit quality of the issuer, the term to maturity and the coupon rate compared to the general interest rate environment at the time. The face value of the bond is what will be returned to the lender once the bond matures. Most bonds can be sold by the initial holder to other investors after they have been issued.

    In other words, a bond investor does not have to hold a bond until its maturity date. It is also common for bonds to be repurchased by the borrower if interest rates fall, or if the borrower’s credit has improved, and can reissue new bonds at a lower cost.

    Many corporate and government bonds are publicly traded; others are only traded over the counter (OTC) or privately between the borrower and the lender.

    Characteristics of the Bonds

    Most of these share some basic common characteristics:

    • The face value is the sum of money the bond will be worth when it matures and serves as a benchmark for the bond issuer for determining interest payments. Consider the scenario when one investor purchases a bond for $1,090 at a premium and another investor purchases the identical bond later when it trades for $980 at a discount. Both investors will receive the bond’s $1,000 face value when it matures.
    • The interest rate, represented as a percentage, that the bond issuer will charge on the bond’s face value is known as the coupon rate.
    • For instance, a 5% coupon rate means that bondholders will get $50 annually, or 5% of the par value of $1,000.
    • The dates on which the bond issuer will pay interest are known as coupon dates. Although payments can be sent at any time interval, semi annual payments are the norm.
    • The bond will mature on the maturity date, at which point the bond issuer will pay the bondholder the bond’s face value.
    • The price at which the bond issuer initially offers the bonds is known as the issue price. Bonds are frequently issued at par.

    The primary factors affecting a bond’s coupon rate are the bond’s credit rating and maturity. These bonds have a higher interest rate and a higher chance of default if the issuer has a low credit rating. Additionally, bonds with exceptionally lengthy maturities typically have higher interest rates. The bondholder is more vulnerable to risks like rising interest rates and inflation over a longer time period, which is why they get paid more.

    Credit rating organizations like Standard and Poor’s, Moody’s, and Fitch Ratings produce credit ratings for businesses and their bonds. Investment grade bonds are the highest rated instruments and include debt issued by the U.S. government and incredibly solid businesses, such numerous utilities.

    High yield or “junk” bonds are described as bonds that are not regarded as investment grade yet are not in default. Investors demand a larger coupon payment for these bonds since they carry a higher risk of default in the future.

    The value of bonds and bond portfolios will fluctuate along with interest rates. Length is a term for how sensitive an investment is to changes in interest rates. Because it does not refer to the amount of time the bond has before maturity, the term “duration” in this context can be unclear to novice bond investors. Instead, duration shows how much a bond’s price will go up or down when interest rates change.

    Convexity is the rate of change in the duration (sensitivity to interest rates of a bond or portfolio of bonds). Due to the complexity of these variables, experts typically carry out the necessary analysis.

    Categories

    There are four main categories of bonds sold in the markets. But on some platforms, you may also be able to find foreign bonds that are issued by global corporations and governments.

    • Companies are the ones who issue corporate bonds. Companies frequently opt to issue bonds as opposed to applying for bank loans since bond markets provide better conditions and lower interest rates.
    • States and municipalities both issue municipal bonds. Tax free coupon income is available to investors in several municipal bonds.
    • Government bonds, such those the U.S. Treasury issues. Treasury bonds having a maturity of one year or less are referred to as “Bills,” those with a maturity of one to ten years are referred to as “Notes,” and those with a maturity of more than ten years are referred to as “Bonds.” “Treasuries” is a common term used to refer to the entire category of bonds issued by a sovereign treasury. Sovereign debt is a term used to describe government bonds issued by sovereign governments.
    • Agency bonds are ones that are issued by businesses with a connection to the government, like Freddie Mac or Fannie Mae.

    Varieties

    Bonds available to investors come in many different varieties. They can be separated by type, interest rate, coupon payment, being called by the issuer, or having other attributes. Below, we list some of the most common variants:

    Zero coupon Bonds

    Zero coupon bonds (Z bonds) do not pay coupons and are instead issued at a discount to their face value that will generate a yield once the bondholder is paid the full face value when the bond matures. U.S. Treasury bills are zero coupon bonds.

    Convertible Bonds

    Convertible bonds are debt instruments with a built in option that allows bondholders to convert their debt into equity (capital) at some point in time, depending on certain conditions such as the stock price. For example, imagine a company that needs a $1 million loan to finance a new project.

    They could take on debt by issuing bonds with a 12% coupon and a 10 year maturity. However, if they knew that there were some investors willing to buy bonds with an 8% coupon that would allow them to convert the bond into shares if the share price rose above a certain value, they might prefer to issue them.

    The convertible bond may be the best solution for the company because it would have lower interest payments while the project is in its early stages. If the investors were to convert their bonds, the other shareholders would be diluted, but the company would not have to pay more interest or principal on the bond.

    Investors who bought a convertible bond may think it is a great solution because they can benefit from the upside of the stock if the project is successful. They are taking on more risk by accepting a lower coupon payment, but the potential reward if the bonds convert could make that trade off acceptable.

    Callable

    Callable bonds also have an embedded option, but it is different from that found in a convertible bond. A callable bond is one that can be “called” by the company before maturity. Suppose a company has borrowed $1 million by issuing bonds with a 10% coupon that mature in 10 years.

    If interest rates fall (or the company’s credit rating improves) in the fifth year, when the company could borrow at 8%, it will redeem or buy back the bonds from the holders for the principal amount and reissue new bonds at a lower coupon rate.

    A callable bond is riskier for the bond buyer because it is more likely to be called when its value is rising. Remember, when interest rates go down, bond prices go up. Therefore, callable bonds are not as valuable as non callable bonds with the same maturity, credit rating, and coupon rate.

    Puttable Bond

    A puttable bond allows bondholders to sell the bond back to the company before maturity. This is useful for investors who are concerned that a bond may lose value, or if they believe interest rates are going to rise and want to recover their principal before the bond loses value.

    In exchange for a lower coupon rate or just to get bond sellers to make the initial loan, the bond issuer may give bondholders the right to sell the bond. A put option bond usually trades at a higher value than a bond without a put option but with the same credit rating, maturity, and coupon rate, because it is more valuable to bondholders. The possible combinations of put, call, and convertibility rights embedded in a bond are infinite, and each is unique.

    There is no strict standard for each of these rights, and some bonds will contain more than one type of “option”, which can make comparisons difficult. Most individual investors rely on bond experts to help them choose individual bonds or bond funds that meet their investment goals.

    How Bonds are Priced

    Bonds are priced by the market based on their particular characteristics. The price of a bond changes every day, just like the price of any other publicly traded security. This price is based on the supply and demand of the bond at any given time. But there is a logic to how bonds are priced. So far, we’ve discussed bonds as if all investors hold them until maturity.

    It is true that if you do, you are guaranteed repayment of principal plus interest; however, a bond does not have to be held to maturity. At any time, a bondholder can sell them on the open market, where the price can fluctuate, sometimes dramatically. The price of a bond changes in response to changes in interest rates in the economy.

    This is due to the fact that for a fixed rate bond, the issuer has committed to paying a coupon based on the face value of the bond, so that for a $1,000 bond at par, with an annual coupon of 10%, the issuer will pay the bondholder $100 each year. Assume that the prevailing interest rates are also 10% at the time this bond is issued, based on the rate of a short term government bond.

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    An investor would be indifferent about whether to invest in the corporate bond or the government bond, since both would yield $100. However, imagine that a little later the economy has taken a turn for the worse and interest rates have dropped to 5%. Now, the investor can only receive $50 from the government bond, but would still receive $100 from the corporate bond.

    This difference makes the corporate bond much more attractive. So, investors in the market will bid up the price of the bond until it trades at a premium that matches the current interest rate environment. In this case, the bond will trade at a price of $2,000, so that the $100 coupon represents 5%.

    Similarly, if interest rates were to shoot up to 15%, then an investor could earn $150 on the government bond and would not pay $1,000 to earn only $100. This bond would be sold until it reached a price that matched the yields, in this case at a price of $666.67.

    Bond Prices and Interest Rates

    This is why the famous statement that the price of a bond varies inversely with interest rates works. When interest rates rise, bond prices fall to have the effect of matching the bond’s interest rate with prevailing rates, and vice versa.

    Another way to illustrate this concept is to consider what the yield on our bond would be if the price changed, rather than if the interest rate changed. For example, if the price were to drop from $1,000 to $800, the yield would rise to 12.5%.

    This is because you are getting the same $100 guaranteed for an asset worth $800 ($100/800). Conversely, if the bond rises in price to $1,200, the yield drops to 8.33% ($100/$1,200). Bond prices in the market react inversely to changes in interest rates.

    Yield to Maturity (YTM)

    The yield to maturity (YTM) of a bond is another way of looking at the price of a bond. YTM is the anticipated total return on a bond if the bond is held to the end of its life. Yield to maturity is considered the yield on a long term bond, but is expressed as an annual rate.

    In other words, it is the internal rate of return on a bond investment if the investor holds the bond to maturity and if all payments are made as scheduled. The YTM is a complicated way to figure out how attractive a bond is compared to other bonds on the market with different coupons and terms. However, the idea behind it is quite useful.

    The YTM formula involves solving for the interest rate in the following equation, which is no easy task, and therefore most bond investors interested in YTM will use a computer:

    YTM = Face Value Present Value n 1

    We can also measure expected changes in bond prices in the face of a change in interest rates with a measure known as the duration of a bond. Duration is measured in years because it was first used to talk about zero coupon bonds, whose duration is their maturity date.

    In real life, however, duration shows how much the price of a bond changes when interest rates change by 1%. We call this second, more practical definition the modified duration of a bond.

    Duration can be calculated to determine the price sensitivity to interest rate changes for a single bond, or for a portfolio of many bonds. In general, bonds with long maturities and low coupons have the highest sensitivity to changes in interest rates. The duration of a bond is not a linear measure of risk. This means that as prices and interest rates change, so does the duration itself, and convexity is a way to figure out how these things are related.

    Bond Example

    A bond represents a borrower’s promise to pay a lender the principal and, usually, interest on a loan. Bonds are issued by governments, municipalities, and corporations. The interest rate (coupon rate), principal amount, and maturities vary from bond to bond to meet the objectives of the bond issuer (borrower) and bond purchaser (lender).

    Most bonds issued by companies include options that can increase or decrease in value, which can make comparisons difficult for non professionals. Bonds can be bought or sold prior to maturity, and many are publicly traded and can be brokered. While governments issue many bonds, corporate bonds can be purchased through brokers. If you are interested in this investment, you will need to choose a broker. You can take a look at Investopedia’s list of the best online brokers to get an idea of which brokers would best suit your needs.

    Since fixed coupon bonds will pay the same percentage of their face value over time, the market price of the bond will fluctuate as that coupon becomes more or less attractive compared to prevailing interest rates. Imagine a bond issued with a 5% coupon and a face value of $1,000. Interest of $50 will be paid to the bondholder every year. Most bond coupons are halfed and paid every six months.

    As long as nothing else changes in the interest rate environment, the price of the bond should remain at face value. However, if interest rates start to fall and similar bonds are now issued with a 4% coupon, the original bond will have become more valuable. Investors who want a higher coupon will have to pay more for the bond to convince the original owner to sell it.

    The increase in price will bring the total bond yield down to 4% for new investors, because they will have to pay an amount above face value to buy the bond. On the other hand, if interest rates rise and the coupon rate on bonds such as this one rises to 6%, the 5% coupon becomes unattractive. The price of the bond will decline and it will begin to sell at a discount to face value until its effective yield is 6%.

    Real-World Examples of Bond Investments

    1. U.S. Liberty Bonds: Funding Wars and Building Nations

    Liberty Bonds were issued by the US government to raise money for the war effort during World War I. By purchasing these bonds, Americans were able to support their government’s future while also demonstrating their patriotism. These bonds’ success served as a catalyst for additional government borrowing, demonstrating the usefulness of bonds for domestic funding.

    2. Corporate Bonds: The Apple Inc. Case

    Take Apple Inc. as an example, which raised money by issuing corporate bonds. Apple released a $7 billion bond with adjustable interest rates and maturities in 2017. The money obtained was put toward expansion initiatives and shareholder returns, among other company uses. This illustration demonstrates how well-known businesses are using the bond market to raise significant amounts of capital.

    3. Financing Infrastructure: The Role of Municipal Bonds

    Financing local initiatives has been made possible in large part by municipal bonds. For instance, the city of Los Angeles issued municipal bonds to pay for the development of transportation infrastructure and public schools. These bonds supported essential community development while giving investors tax-exempt income.

    4. Samurai Bonds: Bridging International Markets

    Samurai bonds, which are bonds issued in Tokyo by non-Japanese companies denominated in Japanese yen, provide insight into the global bond market. Samurai bonds are a global kind of bond financing; companies like Tesla have used them to entice Japanese investors.

    5. The 2008 Financial Crisis and Corporate Bonds

    Many businesses issued bonds during the 2008 financial crisis because of a lack of bank financing. These bonds gave businesses a different source of funding, which helped them weather the financial storm.

    6. The Individual Investor: A Story of Diversification and Stability

    John, a retail investor, added corporate and government bonds to diversify his holdings. He opted for high-yield corporate bonds because to their potential for greater profits and US Treasury bonds due to their safety. This combination provided him with a consistent income stream and stability through market changes.

    7. Interest Rate Fluctuations: The Fed’s Impact on Bond Prices

    The 2018 interest rate hike by the Federal Reserve had a big effect on bond prices. While the boost resulted in a decline in bond prices, it provided new investors with higher returns. This hypothetical situation highlights the direct impact of economic policy on the bond market.

    8. Pandemic Response: Government Bonds in 2020

    Governments everywhere, including the US, released bonds in reaction to the COVID-19 epidemic to pay for emergency protocols and economic stimulus plans. Governments were able to swiftly mobilize financial resources to address the crisis thanks to these bonds.

    Wrap Up

    As a sort of fixed income investment, bonds represent a loan that an investor makes to a borrower, typically a business or a government. A promissory note outlining the loan’s terms, including the due date for the principal and interest payments, is issued by the bond’s issuer.

    The initial holder of the bonds can sell them to other investors once they are issued, and organizations can use them to raise money for operations and initiatives. There are numerous types of bonds, and the majority of them have fundamental characteristics in common, like the coupon rate, maturity date, and face value.

    While some bonds are exclusively exchanged privately or over-the-counter, others are traded publicly. Bonds give investors the chance to profit from their investment while giving businesses a way to finance their operations.

    FAQs

    What is a Bond?
    Understand the Fundamentals of Bonds: Definition, Pricing and Real-World Examples

    A bond is a fixed income investment in which an investor lends money to a borrower (such as a business or the government) on the condition that the investor will receive regular interest payments and that the principal loan will eventually be repaid.

    Who Publishes Bonds?

    Businesses, communities, states, and sovereign governments can issue bonds to raise money for a range of uses, including project finance, business operations, and absorbing unforeseen costs.

    How do Bonds Work?

    When an issuer needs to raise capital, it issues a bond that specifies the loan’s terms, the interest payments required, and the due date for the principle repayment.

    Owners of bonds receive interest payments in return for lending money to the issuer. Bond market prices are influenced by a number of variables, including the issuer’s credit standing, the bond’s maturity date, and the coupon rate.

    What is the Face Value of a Bond?

    A bond’s face value is the sum that will be given back to the lender when it matures. Typically, it costs $1,000 for each individual bond.

    Can an Investor sell their Bond before the Maturity Date?

    Yes, a bond holder is not required to keep a bond until it matures. Most bonds can be repurchased by the borrower if interest rates decline or their credit rating improves, or they can be sold to other investors after they have been issued.

    What is an example of a Bond?

    To illustrate, consider the case of XYZ Corporation. XYZ wishes to borrow $1 million to finance the construction of a new factory, but is unable to obtain this financing from a bank. Instead, XYZ decides to raise the money by selling $1 million worth of bonds to investors.

    Under the terms of the bonds, XYZ agrees to pay its bondholders interest at 5% per annum for five years, with semi annual payments. Each of the bonds has a face value of $1,000, which means that XYZ sells a total of 1,000 bonds.

    What types of Bonds are There?

    The above example is a typical bond, but there are many special types of bonds. For example, zero coupon bonds do not pay interest during the term of the bond. Instead, their face value (the amount they return to the investor at the end of the term) is greater than the amount paid by the investor when the bond was purchased.

    Convertible bonds, on the other hand, give the bondholder the right to exchange his bond for shares of the issuing company if certain targets are met. There are many other types of bonds, offering features related to tax planning, inflation hedging and others.

    Are bonds a Good Investment?

    Bonds tend to be less volatile than stocks, and it is usually recommended that they form at least part of a diversified portfolio. Since bond prices vary inversely with interest rates, they tend to appreciate in value when rates fall.

    If bonds are held to maturity, they will repay the full principal amount at the end, along with interest payments made along the way. Therefore, bonds are often good for income seeking investors who want to preserve capital. In general, experts advise that as people age or approach retirement, their portfolio weighting should be weighted more toward bonds.

    How do I buy Bonds?

    While there are some specialized bond brokers, today most online and discount brokers offer access to the bond markets, and you can buy bonds more or less as you would stocks.

    Treasury bonds and TIPS are usually sold directly through the federal government, and can be purchased through its TreasuryDirect website. You can also buy bonds indirectly through fixed income ETFs or mutual funds that invest in a portfolio of bonds.

    Article sources

    At Capital Maniacs, we are committed to providing accurate and reliable information on a wide range of financial topics. In order to achieve this, we rely on the use of primary sources and corroborated secondary sources to support the content of our articles.

    Primary sources, such as financial statements and government reports, provide firsthand evidence of financial events and trends. By using primary sources, we are able to directly reference information provided by the organizations and individuals involved in these events.

    Secondary sources, such as financial analysis and commentary, interpret and analyze primary sources. While these sources can be useful for providing context and background information, it is important to use corroborated sources in order to ensure the accuracy and reliability of the information we present.

    We take pride in properly citing all of our sources, both primary and secondary, in order to give credit to the original authors and to allow our readers to verify the information for themselves. We appreciate your trust in our website and are committed to upholding the highest standards of financial journalism.

    1. U.S. Securities and Exchange Commission – Coupon Rate
    2. Financial Industry Regulatory Authority – Bond Basics
    3. U.S. Securities and Exchange Commission – High-yield Bond (or Junk Bond)
    4. U.S. Securities and Exchange Commission – Convertible Securities
    5. U.S. Securities and Exchange Commission – Callable Bonds (or Redeemable Bonds)
    6. U.S. Securities and Exchange Commission – Investor Bulletin: Fixed Income Investments — When Interest Rates Go Up, Prices of Fixed-Rate Bonds Fall
    7. U.S. Securities and Exchange Commission – Zero Coupon Bond

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